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Exclusive Research: Nearing the Top?

Previously bullish sentiments in the office sector have begun to wane.

Although it has not been the star of this extended commercial real estate cycle, the office sector has delivered its fair share of strong performance and solid returns. Occupancy rates and rents rose, cap rates fell and development has been kept in check.

But now, for the first time in the five years since NREI began its exclusive research gauging sentiment in the sector, cracks have begun to emerge. That’s not to say it’s time to worry. A majority or clear plurality of respondents for each question indicated a belief that fundamentals have more room to improve. Yet across the board, the sentiment has begun to turn.

Fewer respondents answered in the most unequivocally bullish ways for each question. Moreover, in answers to new questions added to this year’s research there’s a clear sense that trends like co-working and telecommuting are having an impact.

For example, respondents were asked to rank the relative strength of their region on a scale of 1 to 10. The West (7.7) led the way, followed by the South (7.5), the East (7.0) and the Midwest (6.5). However, the scores for each region showed a noticeable decline from a year ago, falling by between 20 basis points and 50 basis points across the board.

Following the money

Respondents were asked to estimate cap rates in their regions and nationally and generated figures of 6.1 percent and 6.0 percent, respectively. Those numbers are a bit lower than market statistics suggest. CBRE’s most recent U.S. cap rate survey placed central business district (CBD) cap rates at 6.7 percent and suburban cap rates at 7.9 percent as of the second half of 2018.

For the fifth consecutive year, a majority of respondents said they expect cap rates on office properties to rise in the next 12 months. This year, 66 percent of respondents said they expect rates to rise, down from 73 percent a year ago. Meanwhile 16 percent said they expect cap rates in their region to decrease in the next 12 months, up slightly from 14 percent in 2018. About one-fifth of respondents (18 percent) said they expect no change.

The numbers are similar at the national level, where 68 percent expect cap rates to increase (down from 75 percent in 2018), while 18 percent expect them to decrease (up from 14 percent from a year ago) and 14 percent expect no change.

Respondents were also asked about the outlook for CBD office properties in comparison to suburban complexes. Responses were similar for both property types and mirrored overall sentiment for the sector.

In both cases, about two-thirds of respondents expect cap rates to increase (63 percent for CBD, 65 percent for suburban), while about one-quarter expect cap rates to decrease (23 percent for CBD and 24 percent suburban). For both sectors, the percentage of respondents expecting increases in cap rates fell from 2018’s levels.

As in 2018, respondents in this year’s survey ranked CBD buildings and suburban properties as equally attractive (exactly 50.0 percent for each). But when it came to projecting which type of investment offers higher long-term yields, suburban (52.2 percent) slightly edged out CBD office buildings (47.7 percent).

As of May 2018, suburban office values outperformed CBD offices on a three-year basis, according to Real Capital Analytics’ Commercial Property Price Indices (CPPI). RCA’s CPPI registered that CBD office pricing has gone down 2.0 percent since it peaked in November 2017 and 0.3 percent year-over-year, while suburban office pricing rose 6.2 percent since last November and 8.5 percent year-over-year.

In a new question, we asked respondents if there has been an increase in the number of high-profile office properties coming up for sale. In all, 51 percent said there has been an increase (44 percent said the increase was “moderate” and 7 percent said it was “significant”). Another 30 percent said there had been no change. Only 8 percent said there had been a decrease.

As to why that might be, one respondent wrote, “Investors wanting to sell since there is not much more room for rent increases in the foreseeable future.”

For example, New York’s iconic Chrysler Building is currently on the market. Abu Dhabi, which is the Chrysler Building’s majority owner through its sovereign wealth fund, is said to have hired CBRE Group to market the property, according to Bloomberg. The fund paid $800 million for a 90 percent stake in the building in 2008.

Respondents indicated little change in their plans for buying, holding or selling office properties. Just more than three-fifths (60.5 percent) said they expect to “hold” properties in the sector in the next 12 months (up slightly from 57.1 percent in 2018). Less than one-fifth expect to sell (17.1 percent compared to 20.7 percent in 2018) and a slightly greater percentage is looking to buy (22.4 percent vs. 22.1 percent in 2018).

In terms of capital availability, responses indicated that capital markets remain stable. About 54 percent of respondents said capital availability was unchanged for both debt and equity for the office sector (53.7 percent for equity and 53.6 percent for debt), while about one-sixth said capital was more widely available (14.8 percent for equity, 14.2 percent for debt). And one-fifth of respondents said it was less available (20.8 percent for equity, 19.2 percent for debt).

Respondents were also asked how they see various financing aspects changing in the next 12 months.

While a majority expect interest rates to rise, there’s growing sentiment that rate increases may be coming to an end. Overall, 64 percent said they expect rates to increase, which is down from 87.8 percent in 2018. Instead, 31 percent said they will remain flat (up from 12.2 percent in 2018).

When it comes to the risk premium—the spread between the risk-free 10-year Treasury and cap rates—respondents were split, with 46 percent expecting an increase while 43 percent expect it to remain the same.

Two factors that a majority of respondents again do not expect to see much movement on are loan-to-value (LTV) ratios and debt service coverage ratios (DSCR). About three-fifths (63 percent on LTV rates and 59 percent on DSCR) expect those metrics to remain flat. Those numbers are down just slightly from a year ago.

In addition, 44.1 percent of respondents to this year’s survey expect loan terms to tighten, slightly down from 46.6 percent who answered that way in 2018. In this year’s survey, 44.7 percent said loan terms would remain unchanged (up from 39.9 percent in 2018), while only 11.2 percent expect them to loosen (down from 13.6 percent in 2018).

Prospects for leasing

The biggest shift in sentiment from previous surveys was on occupancy rates. While a majority of respondents said they expect occupancy rates in their regions to increase (53.3 percent), that represented a 16 percentage point drop from the 2018 survey (69.3 percent). Meanwhile, the number of respondents saying that occupancy rates in their region will decline jumped from 17.7 percent in 2018 to 30.2 percent this year. (Another 17 percent said occupancies would remain flat.)

Respondents were even slightly more bearish on the national picture, with 50.7 percent saying occupancy rates would rise (down from 63.1 percent in 2018) and 37.8 percent saying rates would decline (up from 24.2 percent last year).

That level of bearishness was not tied to concerns of overdevelopment. Overall, just 24.0 percent of respondents said there is too much development of office space in their region. (Although that figure was up from 18.5 percent in 2018.) On balance, a majority said the level of development is the “right amount” (52.0 percent), while another 13.9 percent said there is “too little” development and 10.1 percent said they were not sure.

When asked to estimate how much additional supply their market could absorb, 28.8 percent said their market could absorb less than 5 percent of current inventory. Another 26.7 percent answered “5 percent to 9 percent” and 22.6 percent said “10 percent to 14 percent.”

In the first two quarters of 2018, the U.S. office market experienced the influx of 28.8 million sq. ft. of new space, according to real estate services firm Cushman& Wakefield. This was higher than the amount of new space delivered during the same period in 2017. By year-end 2018, new office deliveries should have reached 68.4 million sq. ft. “Developers are playing catch up now,” according to David Bitner, head of Americas capital markets research with Cushman & Wakefield. “The last three cycles had a lot more construction relative to inventory.”

Bitner expects developers to begin pulling back in 2019, with 54.7 million sq. ft. in new office deliveries projected for the year. This figure is based on projects under construction, which take approximately two years to complete.

Meanwhile, on rents, there were not many concerns. Overall, about three-fourths of respondents (75.8 percent) expect rents to rise in the next 12 months, while only 14.6 percent expect them to decrease. Those figures were not much different from 2018, when 77.9 percent said rents would rise and 12.7 percent said they would decrease.

According to CBRE, as of last summer, the top five markets for office construction included Manhattan, with 16.69 million sq. ft. of space; San Francisco, with 8.50 million sq. ft. of space; Washington, D.C., with 7.46 million sq. ft. of space; Seattle, with 5.53 million sq. ft. of space; and Dallas/Ft. Worth, with 5.11 million sq. ft. of space.

In a new question for this year’s report, we asked readers to identify how active certain tenants have been in the market on a scale of one to five, with five being “extremely active.” Tech firms (3.9) topped the list by a large margin, whereas FIRE firms (3.0), small businesses (3.0) and law firms (2.9) all finished with similar marks.

We also asked respondents how the rise of co-working operators and the increase of telecommuting was affecting office leasing.

In terms of co-working, 34 percent of respondents said it has been a mild net negative and 5 percent said it has been a significant net negative. Another 23 percent said it has not been a factor. And 22 percent said it has been a mild net positive, while 6 percent said it has been a significant net positive.

Meanwhile, a majority of respondents (60 percent) said telecommuting has resulted in a moderate decrease in the amount of office space needed per employee. Another 10 percent said it led to a significant decrease, while 21 percent said it has had no impact. Not surprisingly, almost no respondents said telecommuting was leading to an increase in demand for space.

“Telecommuting is a draw, but not too significant here yet, and finding the right fit for the tenant is a concern,” one respondent wrote. “But the opportunity is there if you have the ability to provide the amenities that the tenant is willing to pay for, i.e., in a well-defined and well-recognized location that is highly visible from the highway, and in an area that is highly visited by the public.”


Similarly, 53 percent of respondents said tenants are asking for less space than in the past vs. 27 percent that said there has been no change and only 7 percent saying tenants are asking for more space.

More than half of respondents (54 percent) also indicated that they are seeing fewer tenants opt for traditional office layouts, preferring more open office plans. Another 30 percent said the amount of each type has been about the same. Only 7 percent said they are seeing more tenants opt for traditional office layouts and fewer open-office plans.

As one respondent wrote, “The major office consumers in our market are tending towards less space and more collaboration area, but there also some cracks in the enthusiasm for this concept, so that there may well be a return to more panelized or semi-private offices.”

Lastly, just more than one-third of respondents (36 percent) said office lease lengths are becoming shorter, while 45 percent said there is no change. But only 8 percent said office leases are becoming longer. n

Survey methodology: The NREI research report on the office real estate sector was completed via online surveys distributed to readers in February. The survey yielded 350 responses. Half of respondents (50 percent) hold the titles of owner, partner, president, chairman, CEO or CFO. The results from the current research were compared against prior studies completed in early 2018, early 2017, early 2016 and late 2015. The 2015 survey yielded 216 responses, the 2016 survey yielded 371 responses, the 2017 survey yielded 274 responses and the 2018 survey yielded 321 responses.

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